When Europe’s Sovereign Debt Crisis Hits Home

How the European Crisis Will Affect the United States

Europe’s deepening sovereign debt crisis could well be the straw that breaks the camel’s back in the United States, tipping our economy from recovery to decline. But what happens in Europe is beyond the influence of U.S. policymakers. What we can do at home, however, is prepare for a downturn in our exports and a potential rise in the value of the dollar.

But first, let’s look at how the shockwaves from a crisis in Europe might emanate across the Atlantic. The European and the American economies are deeply intertwined. Trade is the major channel through which ongoing stress in the European Union will affect the United States. In 2010, 22.5 percent, or $412 billion worth, of U.S. exports in goods and services went to the European Union. A sharp economic downturn in Europe means demand for U.S. products and services is likely to decline significantly.

But that’s not all. U.S. exports of intermediate goods and services to other countries that export to the Euro area may also go down, as well as U.S. exports to countries that are generally affected by a slowdown in Europe. Falling U.S. exports will be an additional drag on the economy and on jobs at a time when America can least afford it.

The reason: Exports are one part of the otherwise struggling U.S. economy that have been doing well. Exports grew by 11.3 percent in inflation-adjusted terms in 2010. This was the fastest growth rate since 1997. Data for 2011 show that exports have remained strong so far, overcoming weaknesses elsewhere, such as in consumer spending, but a drop in U.S. exports related to any crisis in Europe would shake already-fragile business and consumer confidence in the United States.

In addition to slowing demand in Europe and affected parts of the world, the impact of a European crisis on exchange rates will also hurt the United States. The trade-weighted Euro, which is a weighted average of exchange rates with the weight for each foreign country equal to its share in trade, continues to be about 10 percent weaker than it was in 2009. As the trade-weighted value of the Euro goes down, it means that the currencies of other partners, the U.S. dollar in particular, become worth more and European exports to America become cheaper.

At the same time, an appreciation of the dollar relative to the Euro makes U.S. exports to Europe more expensive. There is usually a significant lag of about 12 to 18 months between the depreciation of a currency and when its impact on exports is felt, but a sustained decline in the Euro relative to the dollar could have a substantial adverse impact on U.S. exports.

There are other financial risks, too. U.S. banks hold just more than $113 billion in loans to Greece, Ireland, Portugal, and Spain. If some of these loans went bad, there would be losses by banks that could spell continued credit tightening for businesses and consumers in the United States.

Moreover, market gyrations as a result of the turmoil in Europe are already adversely affecting U.S. household retirement and savings investments. If this continues, U.S. households would lose part of their savings. Total household financial wealth fell by $135 million in the second quarter of 2011, as markets wavered in the face of growing concerns over the European sovereign debt crisis. Less wealth means households will save more and consume less, further slowing what is already sluggish growth in the United States.

Looking past the specific mechanisms through which the economic problems in Europe might spill over to the United States, history also reinforces how Europe and the United States have become increasingly connected over the last couple of decades. Indeed, some of the effects of Europe’s struggles are already apparent in the American economy, but growth projections suggest it could get a lot worse.

Growth patterns of the European Union and the United States closely mirror one another. During the recession in 1990, the United States went into recession first, leading the way before Europe’s economic decline. But in the two recessions since, Europe and the United States have gone into recession at the same time. Increasing integration since the 1990s, especially through trade, has bound the U.S. and EU economies closer together. The two reinforce each other’s growth but they also exacerbate one another’s weakness. (see chart)

Today, both the EU and U.S. economies are showing signs of weakness. The seasonally adjusted growth rate for the European Union fell from 1 percent in the first quarter of 2010 compared to the previous quarter, to 0.5 percent in the second quarter and has continued to remain below 1 percent since. GDP growth in France and Germany is also stagnating.

Growth in the United States followed a similar pattern, falling below 1 percent in the second quarter of 2010 and subsequently continuing to fall into the second quarter of this year.

Based on expectations of continued weakness, the International Monetary Fund recently revised its growth estimates for Europe and the United States down for 2011 and 2012 providing further evidence of some synchronicity in the U.S. and Europe’s economic growth patterns. (see table)

It is now reasonably certain that the United States will not escape Europe’s travails unscathed. There is not much we can do about Europe’s troubles but we can do our best to minimize the impact of the blow by implementing measures to create jobs, support workers, and adopt sound fiscal and monetary policies to guard against being dragged into a double-dip recession by the crisis in Europe.

Sabina Dewan is Director of Globalization and International Employment at the Center for American Progress. Christian E. Weller is a Senior Fellow at the Center.